Tax-reform principles: broad base, low rates and no political favors

Dissatisfaction with the U.S. income tax code is virtually universal. Policy makers and commentators of all political stripes agree that the tax code is too complicated, filled with loopholes that mostly favor special interest groups, distort economic decisions in unproductive ways, reduces economic growth and is unfair.

All of these criticisms are correct.

The present income tax code is a quagmire of high and variable rates, filled with loopholes, shelters, credits, deductions and exemptions that cause a good deal of economic loss. Households and firms are induced to make decisions based on their tax consequences instead of underlying economic realities.

Thus, goods are produced in less efficient ways; consumers are moved away from their best choices, resulting in less satisfaction; and incentives for investment, skill acquisition, and work effort are diminished and biased toward tax-favored activities. The consequences are goods and services produced at higher cost, consumers with inferior outcomes, reduced economic welfare, and diminished economic growth.

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There is more bad news. The compliance costs of dealing with a complex tax system are substantial, as individuals and companies spend time and resources determining and reducing taxes. A complex tax code is difficult to enforce, requiring more government resources to do so. Each of these uses resources that could have been devoted to providing more goods and services — and satisfaction — for the citizenry.

Perhaps the worst consequence of the present tax code is that it invites political manipulation and granting favors to special interests. The myriad of loopholes virtually announces to the world that government is willing to provide special privileges to those with enough political clout.

To get ahead in such a world, lots of lobbying is called for, with resources devoted to politicking rather than to the hard work of making better goods and services. Is it any wonder that the public’s opinion of our business and government institutions is so low?

And none of this is fair. People often disagree about fairness, but I suspect that there is no one who thinks the present tax code is fair.

Now the good news. There are feasible ways to deal with these problems. While there is no perfect system of taxation, one that probably comes the closest is a broad-based, low-rate consumption tax without loopholes. A single, low rate applied to all consumption eliminates most tax-induced distortions to choices that make sense for households and businesses.

Taxing consumption removes the double taxation of savings/investment and eliminates one of the present tax impediments to investment and growth. A lower marginal tax rate reduces the tax penalty for greater work effort and investment.

There are several methods to implement this type of tax system and an attractive one is the Hall-Rabushka approach. This approach simplifies taxation via the elimination of loopholes, taxes individuals on their wages and salaries, taxes corporations on their business income, but allows 100 percent deduction of investment expenses.

The latter implies that savings/investment is not taxed and so enhances growth. The absence of loopholes and lower marginal rates simplifies the code, eases compliance and enforcement costs, increases transparency and so is less susceptible to political manipulation, and improves incentives. Each of these promotes economic welfare.

Can it be made fair? One aspect of fairness that most agree on is that it is unfair for the poor to be heavily taxed. Hall-Rabushka, and similar proposals, calls for an exempt amount of personal income that is not subject to tax. Thus, low-income earners are not heavily taxed — indeed, they are not taxed at all.

The tax framework now being considered by Congress has many of the above elements: lower marginal tax rates on individuals and corporations, investment is not taxed, and many loopholes are eliminated. Thus, it has the potential to be a key ingredient in restoring robust economic growth to the economy.

The beauty of economic growth is that everyone readily benefits; the economic pie is larger so one group’s benefit is not at another’s expense. This emphasis is much preferred since it avoids descending into class warfare that further erodes our already-frayed social fabric.

John Garen is the BB&T Professor of Economics at the Gatton College of Business and Economics at the University of Kentucky.